Introduction
With this article I would like to propose a new ratio, i.e. the “dynamic current ratio”, to assess a
company’s liquidity status instead of the static but commonly used ”current ratio”. I will briefly
explain the weaknesses with the “current ratio” and its two related ratios called the “quick” or
“acid ratio” and the “cash ratio”. These three ratios are often calculated as a group to provide
the analyst with a more complete picture of the short-term liquidity status of the company being
analyzed compared to using only one of these ratios. Finally, I will describe the dynamic current
ratio and point out the advantages of this ratio in comparison with any combination of the three
aforementioned static ratios.
Current Ratio
Current ratio = Current assets / Current liabilities
Quick Ratio
Quick ratio = Accounts receivable + Cash equivalents + Cash
Current liabilities
As we can see, the quick ratio does not contain any inventory. Accounts receivable are
included but still without any indication as to how easily these receivables can be turned into
cash.
Cash Ratio
Cash ratio = Cash equivalents + Cash
Current liabilities
Since the cash ratio measures only the most liquid of all assets against current liabilities, it is
seen as the most conservative of the three mentioned liquidity ratios. As it is generally
accepted in the accounting literature to maintain a high degree of “prudence” in both the
preparation and analysis of financial statements, the cash ratio may not seem as such a bad
idea. However, I would like to argue that it is a bad idea, since it lacks accuracy.
The cash ratio does not provide a true and fair picture of a company’s short-term liquidity. No
ratio does and no ratio in isolation will ever be able to do this. Nevertheless, I believe that the
dynamic current ratio provides the analyst with a more accurate and complete way of assessing
the short-term liquidity than any of the aforementioned ratios.
In today’s world of credit sales, generally the minimum time a company has to settle its bills is
30 days without adversely affecting its credit relationships. This means that there are at least
12 “risk-free” credit cycles per year. The more management extends its credit cycle, the more
they risk defaulting on their payments. Based on this one can argue that an inventory turnover
ratio of six, meaning that the inventory is exchanged for cash six times per year, represents a
50 percent liquidity, (6 cycles / 12 months = 0.5 = 50%). An inventory turnover ratio of three
would mean that the inventory is 16.67% liquid (3 cycles / 12 months = 0.1667 = 16.67%), and
so forth. Using the following table is a fast way of determining the level of liquidity for either
inventory, accounts receivable or accounts payable for a company with 12 “risk-free” credit
cycles per year:
Liquidity (%) 8.34 16.67 25 33.34 41.67 50 58.33 66.67 75 83.34 91.67 100
Turnover ratio 1 2 3 4 5 6 7 8 9 10 11 12
Knowing the turnover ratios for inventory, accounts receivable and accounts payable we can
apply the above percentages to calculate the dynamic current ratio. An example is presented
below:
Current assets
Inventory = $100,000 , Accounts receivable = $20,000 , Cash equiv. = $10,000 , Cash = $5,000
Current liabilities
Accruals = $ 20,000 , Accounts payable = $50,000 , Notes payable = $10,000
Inventory turnover ratio = 5 = 41.67% liquidity
Accounts receivable turnover ratio = 4 = 33.34% liquidity
Accounts payable turnover ratio = 2 = 100% –16.67% = 83.34% liquidity *
Although an accounts payable turnover ratio of three represents a 83.34 percent liquidity, since
accounts payable are inserted in the denominator, and not the numerator as is the case with
inventory and accounts receivable, the reading of 16.67% must be used in this example.